The dramatic, total collapse of Lehman Brothers Holdings Inc. and the simultaneous economic surrender and forced sale of Merrill Lynch show the stakes in the subprime lending crisis continue to escalate to a level few would have imagined a year ago. These institutions had the bad luck of not being first in the line of failures, and the penalties for their sins are far more severe than those imposed on Bear Stearns in March and Fannie Mae and Freddie Mac this summer. Those private-sector firms received controversial and potentially expensive public assistance that was misguided. It is unlikely the U.S. Treasury will repeat that mistake. But the line of desperate firms struggling with subprime fallout is getting longer and the pleas for help more urgent.

Investors, regulators and lenders now are taking a much closer look under the hood of many financial-sector firms, and they do not like what they see. The oily view rightfully has raised calls for more regulatory oversight of the “shadow banking system” and triggered a global retreat to financial conservatism. The latter has the potential to cause developers of construction projects much greater difficulty in obtaining loans, just as the economy worsens and markets slip.

How bad the financing drought will be is anyone’s guess at this point, but the industry already is feeling the pinch from coast to coast. That pinch has the potential to become a strangle hold not felt since the Great Depression. One financial expert thinks as many as 1,000 banks may fail, many of them regional ones. These institutions are the kind that finance the local and regional projects that are bread and butter of the industry. But there are much larger lenders like Washington Mutual, the nation’s largest thrift, that are staggering.

Other areas of construction also are at risk. The subprime tsunami has engulfed AIG, one of the largest insurers in the world, and its survival was questionable at ENR press time. Beyond its troubled financial arm, the company has po­sitions in services critical to construction, like bonding and workers’ compensation insurance.  The consequences of an AIG failure are unknown, and that is making a federal response to the financial crisis far more difficult.

One thing is clear though: The federal government should not bail out flawed private-sector firms that paid executives huge bonuses as late as last year. A more appropriate response would be to turn on the financial tap for public works that benefit the U.S. as a whole, rather than just a few shareholders. The approach worked in the 1930s, and it will work again. The recent federal support of the Highway Trust Fund is a good start.